FPM is discerning trends and themes in the fund managers
metamorphic landscape. Especially vigilant of established themes as well as emerging ones . Established trends are both at once an issue of concern and an
exploitable transaction opportunity for investors and rain-makers alike. The commercial
premise of this article arbitrages between Established
Alternative Managers (EAMs) and
Fledgling Emerging Managers (FEMs).
The process of institutionalization
of alternative investment managers, namely, hedge funds, private equity et
al is mired in paradoxes and oxymoron.
How can a once boutique nimble investment management team producing above-beta
absolute returns become an unwieldy behemoth and still produce alpha? In
philosophical terms:
"You cannot step into the
same river twice: you will not be the same person and it will not be the same
water" Heraclitus 500 BC
These large institutional asset managers whether Ken Griffin of Citadel or Clifford Asness of AQR started as small partnerships with
an edge. To FPM that’s what the ‘edge’ in hedge funds should mean! Whether it
was their innate talents (almost autistic character traits of principals, such
as card-counting and astute gambling skills), and / or the ability to identify,
exploit and strike at big opportunistic game, allowed these once hungry-and-angry
origin whizz kids to become masters of the universe while compounding 20-30%
annualized returns.
The increasing amount of evidence to support FPM’s
thesis of the paradox of
institutionalization is mounting. We are aware of some giants from the
pantheon of hedge funds returning outside investors’ money and reverting to
family office status. George
Soros and Stanley Druckenmiller are two prominent examples from 2011 ahead
of adherence to new SEC rules on registration in March 2012; there are many
others. This operational reversion to
origins is obviously de-institutionalization. Though managers may cite
change as being for regulatory purposes, i.e. to evade the watchful burden of
increasing scrutiny from financial watchdogs, it is clear that the financial
landscape since the financial crisis of 2007-08 has changed for the venerable
old timers mentioned and the like.
However, some heretofore secretive asset managers
have not so much thrown in the institutionalization towel as elected to join the
process (which we at FPM previously highlighted as the ‘Convergence Story’). To perspicacious FPM principals this evinced ‘asset
gathering’ strategic impetus rather than ‘absolute return performance’ efforts.
Our due diligence in the past has distinguished between ‘asset gatherers’ and ‘performance harvester’ or ‘alpha generation’ operations. The former tend to have numerically less and even relatively lower paid
investment professionals. Asset gatherers are characterized by bigger marketing
department budgets, perhaps wielding big hitters in its sales force and / or
using specialist brokerage / distribution outlets. By implication the star
marketer would also be a partner.
For instance,
the once esoteric Farallon Capital
Management is marketing itself with a nine-page Institutional Investor article
under the financial news service EuroMoney publications. Using the back-story of
its illustrious founder Thomas Meyer stepping down at fifty-five years of age, and
successor Andrew Spokes being announced as the chief. This is a process of
institutionalisation via branding. In corporate
lifecycle terms it is a precursor to eventual floatation and other business
exit strategies. Perhaps a chance for founders to pocket or release some
self-vested equity capital in 10 years or so. In February 2007, Fortress Investment Group became the first U.S. hedge fund
to go public. Other one-stop alternatives managers also saw the exit door like
Blackstone (BX), Och Ziff et al. Some EAMs had the exit door firmly shut in
their face by the ensuing financial crisis which they strangely could not
foretell from their capital markets tea leaves, though they were managing
multi-billion dollars of institutional money under the premise of economic and
financial savvy - Doh!
Of the many
‘pulled’ IPO alternative managers, the potent example I cite is quantitative
algorithm guru Clifford Asness’s AQR
Capital. His fames needs little introduction to hedge fund aficionados, and
needless to say the firm is a heavyweight and managing in excess of US$50 bn at
end 2012. FPM foster pioneer strategies and managers as they tend to display
their real depths of spirited enterprise. Mr Asness is not only a Ph.D professor
who led the group that developed statistical models in 1989 which eventually
formed the Global Alpha at Goldman Sacs, but is an advocate against exorbitant fees prevailing in AI. We have tracked
that he has been spearheading the charge on high fees at least since 2010. Fee
reduction is a necessary feature of the convergence story between mutual fund,
hedge funds, exchange traded funds et al. Whatever Mr Asness’s motives, even if
not altruistic, he seemingly is admitting
that his own technology-based alpha is not especially genius! Perhaps
partly the rationale for AQR’s unsuccessful planned cash-out of 10% stake as
early as July 2007. We commend his fee integrity (yet as a made-billionaire
backstabbing late hedge fund entrants as barriers – You’re ‘Avin Laugh!). In
his own words about the state of the fees from a recent conference speech:
"Most hedge fund strategies
are more about very competent implementation and fair fees and terms
[institutionalization] than they are about 'genius’… Hedge funds generally
offer a nice portfolio (gross of fees!) of passive beta, alpha, and a middle
ground we call hedge fund beta or style premia; but unfortunately, managers
like to charge fees as if it's all alpha”
At FPM we view the ‘branded institutionalization’ of the alternative investments (AI) industry
trend with diligent skepticism. Concerned that a) founding principals with the
innovative investment technology wits are operationally and executively not at
the helm henceforth and b) merely seeing institutionalization as a
stepping-stone opportunity for retirement and/or cashing out from the global
institutional operations they painstakingly established and developed. In
private equity investor partnering parlance ‘divorce and separation’ is the
end. FPM’s reservation on this trend cogitates on the idiom that institutions are now content to invest in
the golden egg but not the goose that laid it! Hence why there is naturally
a lot of noise about backing fledgling emerging managers in the burgeoning alternative
space.
Other than institutionalization features relating
to key man, fees, cashing-out, and regulation there are other salient aspects of
transparency and reputation. These
cannot be irrelevant or ignored concepts, especially now in neural/viral
wired-up multi-media cyber globe. Whistle
blowers, disgruntled staff, disillusioned investors, anti-capitalism
activist, email trails etcetera all become source of unofficial non-public
information. The prevailing reputation
of a manager with small asset under management (AuM) is all important to its
preservation. Otherwise even any alleged fraud can change its fortunes quite
quickly, for the better or worse. Therefore with partnership self-interest they
are less inclined to risk their good repute with fraud or other corporate
misdemeanor mischief or downright shenanigans. Managers consciously protect and
preserve the firm in positive light to the privy circle of co-participants in
the ‘edge’ investment game. Degree of transparency to regulators, or
institutional publicity in media is often minimal in niche partnership
family-office type investment operations. Indeed investment regulation limited
whom unregistered investment vehicles could market itself to (‘qualified
investors’ only), and to whom the manager had obligatory reporting duties.
Since this note's premise explores why size
matters in investments. Investment flexibility and alignment of interests are
other considerations when deciding to park with large managers. For instance, on
investment position sizing, the principals of the partnership may decide that a
high conviction risk-on trade is permissible. Institutional policy tends to be compliant
with oversight regulatory bodies. Bodies which monitor and dictate risk
parameters to larger registered money managers. An essential feature of alternative investment mandates is the scope of flexibility
in investment asset and strategies, within given private placement
memorandum. This flexibility is further watered-down in larger institutions as
key man / principals may delegate investment risk
decisions to vested investment committees.
For example, BAAM started out as family size
operations: In 1990, Blackstone created
fund of hedge funds business to manage the internal assets and that of its
senior managers of the then mainly private equity core business.
FPM’s due diligence identifies institutional
managers by the degree of the managers’ alignment with its clients / investors,
essentially by a ratio measuring principals’ and internal capital to that of
the fund or firm AuM:
So US$1.3 bn of “firm’s and employees” assets of a
total US$46 bn in AuM is the extent of alignment of BAAM fund of hedge funds
business to its clients. This is much much lower ratio than at the turn of
millennium, when alternative investments and industry bellwether Blackstone
Group came into institutional prominence, at the height of the DotCom bubble. BAAM acknowledges its own asset gathering
impetus on the Blackstone website “Over Ten Years of Asset Growth”. To FPM’s long memory BAAM’s current ratio of mutual investment interest
is poor evidence of economic alignment between a firm and its clients. Further,
asset growth is not the same as asset performance.
Often profitable niche business is kept close to
one’s chest and a privy few as a closely guarded money-making secret. How many
professional investors understood or had ‘the edge’ in exploitatively spotting
the US housing bubble through the sub-prime market in 2007-09, and then were also
able to make an ‘absolute’ killing? Certainly only handful of investors, from
reading the Gregory Zuckerman book “The Greatest Trade Ever” concentrating on Paulson and Co.
Damaging reputation to a manager with large
asset-base can lead to assets walking out of the door, which can be successfully
public-relations-managed as an operable hemorrhage, given time. This mega asset
base providing a substantial buffer / margin against sudden multi-million
liquidity shocks is the implicit explanation as to “why big hedge fund gets
bigger”. In the same scenario smaller AuM hedge fund firms founder. Large
institutional investors tending to pile into the perceived relative safe-haven of
hedge funds and other alternatives are sacrificing absolute performance for
cash preservation mandate. Understandable that strong absolute return
performance is incompatible with cash preservation, but here’s the bewilderment.
Even accomplished pension or proprietary capital administrators allocating to
hedge funds are overlooking ‘alpha
generation’ while allocating in an ‘all-about-alpha asset class!’ Further,
these savings administrators believe they have to pay “2/20” fees for core low
volatility portfolio cash preservation mandate. Why don’t they invest directly
in cash bonds! It’s the same mockery and folly as an airline marketing its premium first class seats as plane-crash-risk-proof.
All the seats are the same in the aero plane and subject to the systematic risk
of it going down (unless the first class seats are re-enforced with steel bars
like that cockpit of fast-car drivers or fitted with parachute ejection seats).
Performance of hedge funds as an asset class, as
indicated by a benchmark index average, fared only marginally and negligibly
better than equity market index, such as the S&P 500, over the recent
systematic financial crisis. Then as stock markets recovered from an approximately
50% drawdown, hedge funds underperformed (and some threw in the towel unable to
reach high water mark and thus earn performance fees). In the long-run the
convergence story depicts falling alpha and alignment of hedge fund performance
with market, asset, or strategy index. Achieving index returns by hedge fund portfolio managers
(like conservative FoFs) in absolute return investments is a misnomer or sheer debauchery of AI. Similar to to turning a
thoroughbred racing horse or stallion into a rocking-horse! The tilt in favour of hedge
funds comes from alternative managers being able to acknowledge gross of fees…
[
For a complete business proposal based on this note please email FPM with link]
